Based on a presentation at the Business Valuation Conference of the American Society of Appraisers and the Canadian Institute of Chartered Business Valuators in Miami, Florida, on October 5, 2010. Published in the Journal of Business Valuation (2011, Volume 1), a publication of the Canadian Institute of Chartered Business Valuators.
Fairness opinions and their quality are not generally highly-charged, emotional subjects in Canada. In fact, the most notorious court case in the last several years that addressed fairness opinion issues did not even involve an actual fairness opinion — it was the lack of a fairness opinion that was a point of contention.
In Canada, the securities regulators become more involved in related party issues than do the courts. Even the stock exchanges, through their rules for continued listing, play a larger role than the courts in this area. Two of the securities regulatory authorities (in Ontario and Quebec) have a rule governing related party transactions. This rule involves more than just disclosure, in contrast to the regulatory approach of the Securities and Exchange Commission in the United States which focuses almost exclusively on disclosure when it comes to related party transactions. The Ontario and Quebec rule, in addition to addressing disclosure, mandates "majority of minority" shareholder approval and independent valuations in certain cases.
In 1996, the Ontario Securities Commission (OSC) expressed the belief that standard fairness opinions are more noteworthy for what they do not contain than what they do, and that they usually lack analysis to support the conclusion reached, leaving the reader to speculate. In formulating its rule to regulate related party transactions, the OSC decided that fairness opinions would play no part.
The HudBay Minerals Case
Issues relating to the payment of a success fee to a provider of a fairness opinion have been the subject of regulatory consideration from time to time. A particularly high-profile case in which this occurred involved HudBay Minerals Inc., which in 2009 agreed on a proposed plan of arrangement to acquire Lundin Mining Corporation. A plan of arrangement is a legal process that Canadian companies often use to effect a merger, and requires court approval. One of the main reasons for going the plan of arrangement route is that if the merger involves a share exchange, the shares to be issued to the shareholders of the target company will be exempt from the U.S. registration requirements because the registration is court-approved. This is an important exemption in cases where a significant percentage of the target's shareholders are in the United States.
The HudBay Minerals case involved a hearing before the OSC, the contested issue being whether the acquirer's shareholders should have been given a vote on the transaction. This is one area in which the U.S. had been more regulatory than in Canada — if a public company is issuing shares to acquire another public company in the U.S., the U.S. stock exchanges require shareholder approval of the acquiring company's shareholders if the acquiring company is issuing more than 20% of its outstanding stock. Until recently, Canada had no such limit. If a company listed on the Toronto Stock Exchange (TSX) was issuing shares to acquire a private company, and issuing more than 25% of the number of its outstanding shares, then shareholder approval was required, but there was no limit if it was acquiring a public company. That recently changed so that for TSX companies the 25% threshold applies to the acquisition of both public and private companies, but at the time of the HudBay case there was no automatic TSX shareholder approval requirement. However, the TSX did have the discretion to require shareholder approval on the basis of subjective factors. The TSX did not exercise that discretion in the case of HudBay, and a shareholder of HudBay applied to the OSC to have the TSX's decision reviewed.
The OSC overruled the TSX and required a vote of HudBay shareholders. However, what attracted more attention than the decision itself was a comment the OSC made in its reasons for the decision regarding the success fee that was payable to the provider of the fairness opinion to the special committee of HudBay's board of directors. The OSC said that a success fee throws into question the entire fairness opinion, in light of the conflict of interest the success fee creates. In Canada, success fees are common, and the OSC's comments (which were not germane to the actual decision that the OSC was making) caused somewhat of a panic in the investment dealer community. In a subsequent speech to the Conference Board of Canada, the chair of the OSC panel that made the HudBay decision narrowed the application of the panel's comments on success fees to the facts of the HudBay case and stated that the HudBay reasons did not suggest that success fees must not be paid to providers of fairness opinions. However, the securities regulatory authorities in Ontario and Quebec do prohibit the payment of a success fee to providers of valuations that are required under the rule described below.
Regulation of Transactions Involving Public Companies and their Related Parties
There is a significant difference between Canada and the U.S. in terms of the percentage of public companies that are controlled by a single shareholder or shareholder group. According to the Canadian Institute of Chartered Accountants, 25% of the companies listed in the main Canadian stock exchange index, the S&P/TSX Composite Index, are controlled. For this purpose, a controlled company is defined as having a shareholder or shareholder group owning at least 25% of the outstanding voting shares. By comparison, approximately 8% of the companies listed on the New York Stock Exchange are controlled. In response to that situation, and to the high volume of related party transactions by public companies, the OSC introduced a policy in 1990 stipulating that certain types of related party transactions would be regulated by the OSC. This policy evolved into a rule in Ontario and Quebec which is now called Multilateral Instrument 61-101 – Protection of Minority Security Holders in Special Transactions (MI 61¬101). The rest of the provinces did not follow suit because they believed that the rule was not suited to the smaller companies that were then listed on stock exchanges outside of Ontario and Quebec. However, at the present time MI 61-101, for practical purposes, applies to most public companies across the country, because the TSX Venture Exchange has adopted it, and all Toronto Stock Exchange listed companies are bound by MI 61-101 by virtue of being "reporting issuers" in Ontario.
There are four types of transactions that are covered by MI 61-101: insider bids, issuer bids, business combinations and related party transactions. The rule requires a formal, independent valuation (subject to certain exemptions), not just a fairness opinion. Also required are "majority of minority" shareholder approval (for a business combination or related party transaction) and enhanced disclosure.
As its name suggests, an insider bid is a takeover bid made by an insider of a target company (or in certain cases, a party related to the target company who is not technically an "insider" as defined by securities laws). An insider is generally someone who owns more than 10% of the voting shares of a company, directly or indirectly, or an officer or director of the company. If a takeover bid is an insider bid, there must be a special committee of the board of directors established for the target. The special committee chooses the valuator and supervises the preparation of the valuation, and the bidder pays for the valuation. There are potentially tense moments if the bid is hostile and the special committee does not obtain a valuator or the valuation with due expediency as required by MI 61-101. The securities regulators are often asked to intervene in that situation.
An issuer bid is essentially a takeover bid by a company for its own shares. The regulatory requirements for issuer bids apply generally to the repurchase by the company of its common shares, rather than, for example, the redemption of preferred shares. In addition, MI 61-101 does not apply to normal course purchases on a stock exchange.
A business combination is a normal merger/acquisition type of transaction, where shareholders vote on the merger. MI 61-101 only covers transactions where a related party is involved. The obvious example would be a management buy-out, or a major shareholder buying out the other shareholders. But the rule could also come into play if a related party is obtaining a significant benefit from the transaction that is unavailable to the other shareholders. The board of directors or a special committee of the target must choose a valuator and supervise the preparation of the valuation for a business combination.
A related party transaction under MI 61-101 is essentially a significant transaction between a company and a related party to the company, such as an insider. If a related party transaction is also a business combination, the requirements for a business combination apply rather than the related party transaction requirements. An example of a related party transaction that would be subject to MI 61-101 is a significant property transaction between a company and its major shareholder. MI 61-101 only comes into play if the size of the transaction exceeds 25% of the company's market capitalization.
The requirements for the contents of the valuation are set out in MI 61-101 in general terms. The detailed requirements are not specified, but the standards set by the Investment Industry Regulatory Organization of Canada or the Canadian Institute of Chartered Business Valuators are considered acceptable.
The required subject matter of the valuation depends on the type of transaction. For an insider bid, issuer bid or business combination, the target shares and any non-cash consideration being offered to the target shareholders must be valued. For a related party transaction, the valuation must cover the non-cash assets involved in the transaction. There are certain exceptions that may apply if the consideration being offered to shareholders, or involved in a related party transaction, consists of publicly traded securities having a liquid market (although the shares that would be surrendered by target shareholders in exchange for those publicly traded securities must still be valued).
If a valuation is required, either a summary or it or the full valuation must be contained in the main disclosure document for the transaction. For an insider bid or issuer bid, the main disclosure document is a bid circular sent to the shareholders. For a business combination or related party transaction, it is usually a management information circular for the meeting at which the shareholders are to vote on the transaction.
The valuator must be independent from the related party involved in the transaction. The valuator can have associations with the target, but it cannot have a material relationship with the acquirer of the target or with the entity transacting with the public company in the case of a related party transaction. Whether or not a valuator is independent is a subjective determination by the public company, but MI 61-101 lists certain circumstances in which a valuator is considered not to be independent. Included in the list is the circumstance where the valuator has a material interest in the completion of the transaction. This would preclude the payment of a success fee.
Magna — the Case of the Absent Fairness Opinion
The 2010 case involving Magna International Inc. (Magna) dealt with an area that has generated considerable controversy in Canada over a period of at least three decades: dual class share structures.
Dual class share structures are fairly common in Canada and usually involve two classes of shares: either voting and non-voting shares or subordinate voting (carrying one vote per share) and multiple voting shares (carrying more than one vote per share). The shares with the inferior voting rights are publicly traded while the shares with the superior voting rights may or may not be publicly traded.
With calls from shareholder activists and some members of the financial media for a ban on the public trading of shares with inferior voting rights, dual class share structures were the subject of two major reviews and public hearings by Canadian securities regulators in the 1980s. (Among, other things, the shareholder activists noted that stock exchanges in the U.S. did not list companies with dual class share structures, but the U.S. exchanges did eventually list them with certain restrictions.) Both of the reviews resulted in the conclusion that the dual class share structures would be permitted but that they would be subject to certain rules relating mainly to disclosure.
In 1986, there was somewhat of a major scandal involving voting and non-voting shares. Canadian Tire Corporation, Limited (Canadian Tire) had a non-voting/voting share structure that had been introduced in 1983 when all of the common shares were converted into voting and non-voting shares, with shareholder approval. The meeting materials provided to the shareholders when they voted on this share restructuring disclosed that the non-voting shares would carry "coattails", which referred to share conditions that were designed to ensure that a takeover bid for the voting shares would have to also be made for the non-voting shares. The shareholders approved the change, and three years later, under an agreement involving the major shareholders of Canadian Tire, a takeover bid was made for only the voting shares at an extremely large premium to the market price of the nonvoting and voting shares. The coattail was insufficient to stop this bid. The controversy this created resulted in the OSC holding a hearing and stopping the takeover bid on public interest grounds.
Shortly after the Canadian Tire episode, the Toronto Stock Exchange introduced a rule requiring all newly listed classes of shares with inferior voting rights to carry coattails that met the Exchange's standards. Classes of shares that were already listed were "grandfathered". Prior to that time, a number of companies had coattails, but some did not. One of the grandfathered companies was Magna.
In May of 2010, Magna announced that it proposed to enter a plan of arrangement under which, among other things, it would eliminate its dual class share structure. Magna's share structure at the time was as follows:
" 112 million Class A Subordinate Voting Shares (Class A Shares) – one vote per share
" 727,000 Class B Shares – 300 votes per share – all beneficially owned by a trust for the benefit of Frank Stronach, Magna's founder and Chairman, and certain members of his family
" The outstanding Class B Shares represented 0.6% of the total equity of Magna and 66% of the votes.
Under the proposed share restructuring, Magna would purchase for cancellation all of the outstanding Class B Shares in exchange for 9 million newly issued Class A Shares and U.S.$300 million, altogether representing an 1800% premium to the market price of the Class A Shares before the announcement. In addition, certain amendments would be made to existing consulting agreements with Mr. Stronach and his associated companies, and there would be a reorganization that would have the effect of giving an entity associated with the Stronach trust control over Magna's vehicle electrification business.
A special committee of the Magna board was established, and Magna hired CIBC World Markets (CIBC) as its financial advisor. The terms of engagement with CIBC did not require a fairness opinion or a formal valuation. The transaction was a related party transaction, but of insufficient size to trigger the formal valuation requirement in MI 61-101.
CIBC determined that the dilution to Magna's shareholders from the transaction would be significantly greater than was the case for 15 precedent transactions that CIBC analyzed in which dual class share structures were collapsed. It was not customary for a fairness opinion to include an opinion regarding the likely trading price of a company's securities following the announcement of completion of a transaction. There was a potential for an increase in the trading price of Magna's shares following the transaction, but the amount, timing and duration of any improved trading performance was difficult to predict. Given that the primary rationale for the proposed Arrangement was an increase in the trading price, any fairness opinion would require CIBC to opine on future trading prices which CIBC said were inherently unpredictable. On that basis, CIBC did not consider itself to be in a position to provide a fairness opinion.
The special committee decided to recommend to the board that the transaction be submitted to the Magna shareholders for their approval (including approval of the holders of Class A Shares voting separately as a class), but with no recommendation from the board to the shareholders as to how the shareholders should vote. The board adopted the special committee's recommendation.
There were objections in principle from some institutional investors. Many companies —about 15% of the companies in the TSX/S&P Composite Index — have dual class share structures, and the objecting institutional investors believed that the Magna arrangement would set a bad precedent.
The OSC staff objected to the process that led to the proposed arrangement and the disclosure that was provided to shareholders in the management information circular that was distributed to the shareholders in connection with the shareholders' meeting to vote on the arrangement. As a result, the OSC called a hearing following which the OSC decided not to object to the transaction but to require improved disclosure in an amended management information circular. The enhanced disclosure was mandated in part because of the lack of a fairness opinion. One of the OSC's specific requirements for the amended circular was a clear statement of how CIBC assessed the proposed transaction from a financial perspective and the reasons why it concluded that it could not opine as to the financial fairness of the arrangement. Based on the evidence before it, the OSC was unable to come to a view as to whether the transaction was unfair to the holders of the Class A Shares.
At the shareholders' meeting, the arrangement was approved by 75.3% of the holders of Class A Shares who voted. The share price had risen in response to the announcement of the proposed arrangement, and securities analysts were virtually uniformly positive about the proposal, since in their view the dual class share structure had a discounting effect on the share price. Eliminating the structure, although expensive, would still provide a net benefit to the holders of Class A Shares, according to the analysts. A significant majority of the shareholders agreed, based on their votes.
Following the shareholder vote, it was still necessary for Magna to obtain the approval of the Superior Court of Justice (Ontario) before the arrangement could become effective. The main issue to be determined by the court was whether the transaction was fair and reasonable. Opposing institutional shareholders participated in the hearing, as well as two institutional shareholders that supported the arrangement.
The institutional investors retained Morgan Stanley Canada Limited (Morgan Stanley) as financial experts for purposes of the court hearing. Morgan Stanley expressed the view that the arrangement was capable of being the subject of a fairness (or unfairness) opinion. Precedent transactions where dual class shares were being collapsed did have fairness opinions, and Morgan Stanley noted that the premium paid for the Class B Shares under the proposed Magna arrangement was substantially higher than the median and highest premiums paid in the precedent transactions. On that basis, Morgan Stanley concluded that the consideration being paid in the Magna transaction was not fair, from a financial point of view, to the holders of the Class A Shares. The court noted, however, that Morgan Stanley did not address the subject of future trading prices in arriving at its conclusion. Nevertheless, the essential question being asked by the opposing institutional shareholders was: How can a court conclude that the arrangement is fair and reasonable when Magna's own financial advisor could not provide a fairness opinion?
In arriving at its decision, the court stated that it could not draw an adverse inference from the absence of a fairness opinion. The court viewed the position of the opposing shareholders as implying that a fairness opinion or valuation must be required every time in which the analysis of the financial benefits to be received under an arrangement is at all complex. The court considered such a requirement to be unrealistic in two respects. Firstly, it gave undue credibility to fairness opinions and valuations, particularly insofar as they failed to address the actual values at which the consideration to be received in an arrangement would trade after the arrangement. Secondly, it ignored the reality that, ultimately, the shareholders must make their own decisions regarding the future market value of the consideration.
The court concluded that it could place reliance on three indicators of fairness in the case of the Magna arrangement: the outcome of the shareholder vote, the market's positive reaction to the announcement of the proposed arrangement, and the presence of a liquid market in which the shareholders who opposed the transaction could sell their shares at prices that had not been demonstrated to have been reduced as a result of the announcement of the arrangement. Based on these factors, the court approved the arrangement. The opposing institutional shareholders appealed the decision to the Ontario Divisional Court. The appeal was dismissed and the arrangement was completed.
Despite the comments that have been made by both the OSC and the court as to the limited utility of fairness opinions, it is expected that fairness opinions will continue to be obtained by companies undergoing merger transactions, particularly where conflicts of interest come into play. A fairness opinion is still often viewed as an essential component of the process a board undertakes to ensure that it is fulfilling its fiduciary duties in evaluating a merger proposal. Magna notwithstanding, an absence of a fairness opinion could in some circumstances be viewed in a negative light if a board's conduct in approving a merger is called into question.
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